Introduction

Traditionally, US federal tax law has treated life insurance
quite liberally:

Inside buildup of cash value is not taxed as current income.

Distributions are generally taxed on a FIFO basis.

Death benefits are normally not taxable.

This is good public policy when we contemplate destitute widows
and orphans as the beneficiaries, but not when a flimsy insurance
veneer is tacked on to an investment in the hope of gaining a
generous tax break.
Internal Revenue Code §7702 and §7702A were enacted to
temper these advantages for investment-oriented contracts, by
imposing limitations on premiums and cash values in relation to
death benefits.
Three classes of contracts result:

A policy that doesn’t meet the requirements of §7702
isn’t life insurance at all for federal tax purposes.
In practice, such policies aren’t knowingly sold.

A modified endowment contract (MEC) meets the requirements of
§7702, but not §7702A.
Gain in a MEC is still shielded from taxation as long as
it’s realized through death, but distributions are
subject to LIFO taxation and may incur an excise penalty.

A “non-MEC” contract—one that fulfills all
the requirements of both §7702 and
§7702A—receives all the traditional tax benefits of
life insurance.

Insurers are responsible for compliance with §7702 and, if
the owner elects, §7702A.
They face severe
penalties[1]
even for “slight” or “reasonable”
mistakes, which are all too common due to the difficulty of
understanding and implementing the requirements correctly.
Unlike state nonforfeiture law, which is a reversible translation
of straightforward actuarial formulas into English, §7702
and §7702A merely hint at the intricate calculations that
they ordain.
Dismay awaits anyone who delves into them hoping to come face to
to face with an unambigous algorithm reflected through a glass
darkly by the statutes.
The legislative history is more illuminating, but cannot be
distilled into one unequivocal specification: the drafters
weren’t programmers or actuaries.
Published commentary usually surveys the spectrum of permissible
compliance methods without resolving all the quandaries that
arise along any particular path.
The goal of this monograph is to describe every detail of one
sound path through the §7702 and §7702A
thicket; there are other valid paths, but this is the one
lmi follows.

These specifications apply only to contracts that were issued
since §7702 and §7702A became effective, or that later
become subject to them through loss of grandfathering.
They do not address taxation of MECs: it is assumed that an
existing admin system does that correctly.
For the same reason, they do not address the §7702A(d)
anticipation-of-failure rule, the §72(e)(11)(A)(i)
anti-abuse rule that aggregates all MECs a company issues to
a policyholder in a calendar year, or the §7702(c)(4) rule
that aggregates all contracts of $10,000 or less.

1 Overview of §7702

1 Life insurance contracts must meet one of two tests
prescribed by Internal Revenue Code §7702 in order to
qualify for favorable tax treatment in the United States.
One is the cash value accumulation test (CVAT); the other is
the guideline premium and corridor test (GPT).

2 The CVAT has only one requirement: that the death benefit (DB)
must never be less than a certain corridor factor times the
§7702(f)(2)(A) “cash surrender value” (CSV).
Departing from common industry
usage, the statute defines CSV as account value (AV)
ignoring any surrender charge, loan, reasonable termination
dividend[2],
or dividend
accumulation[3];
some products include certain other items in
CSV[4].
The CVAT corridor factor for each attained age is calculated at
issue under assumptions prescribed by law (¶4/2), always
assuming DBO A.
It normally varies by gender, and sometimes by tobacco use and
underwriting class.

3 The GPT has two requirements that must both be met at all
times.
The first is that the DB must never be less than a certain
corridor factor times the §7702(f)(2)(A) CSV.
The GPT corridor factors vary only by attained age, and not by
gender, tobacco use, or underwriting class.
The corridor factors are more liberal than for the CVAT because
the GPT also imposes premium limits.

4 The second GPT requirement limits cumulative premiums at
each moment.
The limit is the greater of the guideline
single premium (GSP) or the cumulative annual guideline
level premium (GLP).
Both guideline premiums are generally
calculated according to actual contract mechanics, using
assumptions prescribed by law.
The minimum interest
assumption is higher for the GSP than for the GLP.
Unlike
seven-pay premiums used for MEC testing, guideline premiums
are loaded for current expense charges.
The GLP varies by DBO, but the GSP always assumes DBO A.
Guideline premiums are calculated at issue, and do not
automatically change as attained age increases.
They do generally change when benefits change.

5 A product can offer a choice of GPT or CVAT, but one test
must be chosen for each contract when it is issued.
The test chosen generally cannot be changed after
issue[5].
Compared to
the CVAT, the GPT is generally more conservative at early
durations due to a stricter initial premium limit based on
6% interest, but more liberal in later years because of
lower corridor factors.
The CVAT is the simpler and more
flexible §7702 test, but MEC testing can be much simpler for
GPT contracts.
The GPT is preferred in the high net worth
market where the net amount at risk (NAAR) may ultimately
exceed available reinsurance.

1A Overview of §7702A

1 Life insurance receives more favorable tax treatment than
annuities.
§7702A’s intention is to deny preferential treatment
of living benefits on contracts whose early funding is deemed
excessive, by defining them as MECs and exposing them to taxation
under §72(e)(10), (e)(11), and (v).
A life insurance policy becomes a MEC if it is issued in exchange
for a
MEC[6],
or if premiums are paid at a rate more rapid than one seven-pay
premium for each of the first seven years.
Certain changes cause the policy to be treated as a new contract
with an adjusted premium limitation for a new seven-year period.

2 §7702A would have no effect if the death benefit could
be reduced without penalty the day after a large payment.
Therefore, when the death benefit decreases, premium testing
generally has to be repeated as though the lower death
benefit had been in effect since the beginning of the most
recent seven-year test period.
For most policies, retesting is not necessary for decreases
that occur beyond the end of the last seven-year test period.

3 Complex rules prescribe the §7702A treatment of other
contract changes.
Into every CVAT contract §7702A embeds a deemed contract.
Its deemed cash value (DCV) accumulates like the
actual cash value, but under prescribed assumptions.
A premium is “necessary” to the extent it
doesn’t cause the DCV to exceed the net single premium
(NSP) that defines the CVAT corridor.
Any further payment (which would cause the DCV to enter the
corridor) is “unnecessary” premium.
A “material change” occurs, e.g.,
when benefits increase for any reason (even if due solely to
the corridor or to option B), but its recognition may be
deferred until unnecessary premium has been paid.
Notionally, when that happens, the cash value buys a paid-up
policy, and we issue a new contract for the current death
benefit minus the paid-up amount.
The new contract is subject to a new seven-year premium limit.
We don’t actually
issue new policies; we just perform §7702A calculations as
though we had.
For GPT contracts, we calculate no DCV, but
instead treat all premium as necessary and handle changes
under our GPT rules (¶13/2–3).

2 Issue, attained, and maturity age

1 Age means insurance age, nearest (ANB) or last (ALB) birthday
as specified by the contract, as long as it is within one year
of actual
age[7].
For ANB, if two
birthdays are equally near, either age may be used.

2 The issue age is the insurance age on the contract
effective date.
When a contract is backdated, this produces
the correct result because it is the effective date that is
backdated.
§7702 does not allow artificial age adjustments
exceeding one year, such as the setbacks for female or
substandard that were common in the past, or the joint
equivalent age method that is still sometimes used for
survivorship contracts.

3 The insurance age at the beginning of the policy year
defines the attained age, which is used for all off-anniversary
changes.
If an insured born on 1960-01-01
purchases an ANB contract on 2000-07-02 at insurance age 40,
and changes it on 2001-07-01, the day before the first
anniversary, then all §7702 calculations for the change use
age 40, even though the transaction occurs 41 years and 181
days after birth.

4 Rates and values are looked up by attained age as defined
above for §7702A calculations as well.
Thus, when an
off-anniversary material change causes the §7702A(c)(3)(A)(i)
“contract year” not to coincide with any policy year, the
attained age is still the insurance age defined in terms of
the effective date given in the contract.

5 §7702 deems the contract to mature between ages 95 and 100
inclusive.
Contracts maturing for a reduced endowment prior
to age 95 are deemed to mature at age 95.
If the contract
does not specify any maturity age, then age 100 is
used[8].

6 Riders mature when they expire by their terms, or at age
100 if they do not expire.

3 Initial death benefit, premium, dumpins, and §1035
exchanges

1 On the issue date, guideline and seven-pay premiums must
be calculated based on the DB before any payment or §1035
exchange amount is applied; by definition, this DB cannot
exceed the specified amount (SA).
In order to achieve the most
favorable guideline premiums, a contract should generally be
issued at a SA no lower than its corridor DB (¶4/2) after
the initial premium, dumpin, and any estimated §1035
exchange amount are recognized, net of any term rider.
If this is precluded by sales considerations that demand a
lower SA, then that lower SA becomes the DB for initial
guideline and seven-pay premiums.
Using any higher amount
would expose the contract to §7702A difficulties: if poor
investment performance caused the DB to decrease, then the
seven-pay test would need to be reapplied retrospectively
using the decreased DB.
If the original seven-pay premium
was paid on the issue date and such a decrease occurred more
than sixty days after the first anniversary but before the
eighth year, then the contract would become an irremediable MEC.

2 In certain sales situations, we may elect to use a lower
amount for initial §7702 and §7702A calculations.
For instance, if it is intended to take a $10,000 withdrawal
from a $100,000 policy in the first seven years, we may
choose to treat the initial death benefit as $90,000.
Then we need not recognize a decrease or an adjustment event when
the $10,000 withdrawal occurs.
This requires adding an extra
input parameter to existing systems.

3 In general, we should perform §1035 calculations at issue,
using an assumed §1035 amount.
The old contract is assigned
to us and we surrender it, perhaps some months after the new
contract was issued.
When we get the actual funds, we redo
the §7702 and §7702A calculations as though we had known the
correct amount on the issue date.
To prevent the later
receipt of the rollover from causing a material change or an
adjustment event, it is important not to underestimate the
§1035 amount.

4 Cash values and benefits

1 Cash surrender value (CSV) for all §7702 and §7702A
purposes is the amount payable on full surrender, treating
surrender charges and policy loans as though they did not exist.
It equals account value (whether loaned or unloaned) plus any
extra amounts payable on surrender other than dividend
accumulations or reasonable termination
dividends[9].
The specifications for some products
deem certain additional amounts to be included in CSV for
determining the corridor DB: for example, a refundable sales
load or an experience-rating “reserve”.
Fortunately, adjustment events and material changes do not cause
recalculation of the add-on amounts in either of these
particular examples, although §7702A(c)(2)(A) decreases do
require such a
recalculation[10].
Actuaries contemplating such
add-ons for new products should strive to avoid any
dependency that would cause such a recalculation.

2 Death benefit is the amount payable by reason of death.
To satisfy the §7702 definition of life insurance, it must
never be less than a corridor factor times the CSV.
The GPT corridor factors are given in the
statute[11].
The CVAT corridor factors are the reciprocal of the sum of the
NSP and the present value of any
qualified additional benefit (QAB)
charges[12].

3 Decreasing benefits specified in the contract, for instance in
the case of decreasing term, must be taken into account;
lmi does not address such benefits at this time.
Riders that terminate before maturity may be handled under
the QAB rules.

4 Decreasing benefits not specified in the contract need not
be taken into account.
Where an elective decrease is
intended, we should reduce the initial death benefit (¶3/2).

5 Increasing benefits can be taken into account prospectively
only if they are specified in the contract itself, and then only
to the extent they do not increase the NAAR.
This includes the usual option B when it is elected.
Increases not specified in the contract are always ignored.
It makes no difference that such increases follow a specific
pattern specified in advance, as in a letter from the owner
or an illustration signed by the owner, because even such
manifest intentions are not bound to be performed.
It makes no difference that the contract contains a provision
allowing such increases to be elected at the owner’s option.

6 The §7702A CVAT DCV always uses the actual death benefit
option, but the usual return of premium (ROP) death benefit
option is generally treated as option A for guideline
premium purposes (but for ROP forceouts see ¶6/4).
Therefore, a change from
option A to ROP or ROP to A is not an adjustment event.
In theory, for ROP we could take into account increases up to
the option B amount, but only to the extent they are certain
to occur; yet this is awkward or impossible to apply when
the premium is flexible.

7 Increasing benefits specified in the contract that do
increase the NAAR must be taken into account as they occur.
For instance, a “jumping juvenile” contract that provides a
death benefit of $1000 per unit through age 20, and $5000
per unit from age 21 on, has an adjustment event at age 21.
It is treated exactly the same as a level contract with an
elective increase at age 21.

8 §7702 and §7702A calculations take an endowment benefit
into account.
But if the contract specifies a reduced
endowment benefit (as some retirement income policies do),
then the endowment benefit cannot exceed that reduced amount
(lmi does not support this).
Initially, the endowment benefit is the SA at issue.
For CVAT contracts, it is reset
to the new SA upon each material change.
For GPT contracts,
it is reset to the new SA upon each adjustment event, but
only with respect to the seven-pay premium and the quantity
B in the
A + B − C
formula (¶5/4); the quantities A and C
use the SA immediately prior to the adjustment
event[13].

5 Post-issue changes

1 Guideline premiums are recalculated whenever certain
changes (“adjustment events”) occur.
Adjustment events include
changes in SA, if and only if DB also changes,
changes in death benefit option,
changes in QABs,
reductions in substandard table ratings or flat extras, including rider ratings, and
changes in the §7702 mortality or interest basis.
These transactions are adjustment events only if they change
factors or values actually used in the guideline calculations;
for instance, if the implementation conservatively ignores
substandard charges and QABs, then no adjustment event arises
when they change.
The server must
nevertheless be notified of all such changes, because an
insurer might amend its current practices at any time.
Automatic adjustments in the DB of an “integrated” (¶11/8)
term rider due to the corridor are not adjustment events if
the total DB does not change; early termination of the rider
and voluntary changes in its SA are adjustment events if the
total DB changes.
Since an adjustment event may be triggered
by any transaction that affects the SA, we must test all
withdrawals.
Refer all cases of misstatement of age or gender to the actuarial
department[14].

2 The owner cannot directly change the DB, because the
contract’s elective increase and decrease provisions apply
specifically to the SA only.
A change in SA is not an
adjustment event if the DB does not also change—for example,
a $10,000 SA increase on an option A contract with a $100,000 SA
and a $150,000 corridor DB is not an adjustment event.
But there may be an adjustment event in this example
due to some other cause, for instance if the DBO is changed
on the same date.

3 A DBO change is an adjustment event (but see ¶4/6) even
if it doesn’t cause the SA or the DB to change, because it
directly affects the GLP calculation (¶14.3/1).
When a DBO change is the only adjustment event, GSP does not
change, because by definition it is independent of DBO.
In that circumstance, recalculating GSP is a superfluous step
that leaves the value unchanged.
It may be performed anyway if that is simpler than writing code
to anticipate and avoid this special case, or it may be omitted.

4 Recalculations follow the
A + B − C
method.
The formula is:
A = guideline premium before change
B = guideline premium at attained age for new DB and new DBO
C = guideline premium at attained age for old DB and old DBO
new guideline premium = A + B − C
This formula is applied to both the GLP and the GSP (which
latter never varies by DBO).
The new GLP and GSP apply until
the next change, and are used as the quantity A above in
calculating the effect of any subsequent change.

5 Special care must be taken in defining the benefit amount
for B and C above.
Some older published actuarial
commentary, citing §7702(f)(7)(A), suggests using the SA
(thus, significantly, ignoring the corridor), but the
drafters considered a contract in the corridor as fully
funded for the corridor amount, making any premium increase
with respect to the corridor redundant.
For instance, consider an option A contract with a $100,000 SA
and a $150,000 corridor DB.
A $1 SA increase should not cause the
guideline limit to increase substantially if at all.
A $1 SA decrease should not cause the guideline limit to increase
at all.
Following this reasoning, IRS might look askance at a
strategy of increasing the SA in exact anticipation of each
corridor increase.

6 Instead we define B and C according to §7702(f)(3): “the
term ‘death benefit’ means the amount payable by reason of
the death of the insured”. This ensures that no extra
allowance is given for extra death benefit that has arisen
due to the corridor.

7 The “old DB” is captured before the day’s transactions are
applied, using the current day’s corridor factor and the
latest unit values available at that moment.
It is not altered as a result of the day’s transactions.
For instance, if SA is increased on the same day as a premium
payment, then the potential adjustment event is processed
ignoring the premium.
The premium does not affect the “old DB”, even
if it would otherwise drive the contract into the
corridor[15].
Neither does it affect the “new DB” because adjustments must
be processed before premium can be accepted (¶5/8).

8 Events occurring on different days are never combined.
All adjustment events and material changes that occur on the
same date are combined together and processed as one single
change.
This is done as soon as all transactions that
potentially create adjustment events have been applied, and
must be done before any new premium is accepted because an
adjustment can affect the guideline premium limit.
This aggregation is impossible in the case of a DB increase due
to a payment under the ROP
DBO[16]
because the payment changes
the SA and potentially the DB, but other adjustment events
must be processed before the payment is accepted.
Furthermore, any such increase is not a material change due
to the necessary premium exception.
Therefore, we ignore DB
increases arising out of the normal operation of the ROP
benefit, treating them no more liberally than corridor DB
increases.
This means that the guideline limit would be
higher on an otherwise identical option A contract with
elective SA increases tailored to match the ROP DB pattern.

9 If the guideline limit becomes negative, ensuing
forceouts may eventually reduce CSV to
zero[17];
in that case,
§7702(f)(6) might justify maintaining the contract
effectively as term insurance (¶6/7).
Alternatively, administrative practice can simply forbid any
change that would reduce the guideline limit to an amount less
than zero.

10 Off-anniversary changes never amend past history.
They have only a prospective effect on guideline premiums, which
are linearly interpolated between A and
(A + B − C)
according to the proportion of the policy year completed at
the time of the change.
For example, if a contract with a
$10,000 GLP is changed 249 days after its anniversary in a
leap year, such that its new GLP by the
A + B − C method
is $46,600, then the GLP limit for that policy year is $21,700:
$21,700 = 10,000 × [249 ÷ 366] + 46,600 × [1 − (249 ÷ 366)]
Any fraction of a cent must be discarded.
lmi does not perform the interpolation because
illustration systems generally do not allow such changes.

11 Less favorable taxation (under §72, without considering
the exception in §72(e)(5)) applies to cash distributions
accompanied by benefit reductions within the first fifteen
years from the issue date actually shown in the contract.
This issue date is not adjusted when §7702 or §7702A
merely deems the contract to be reissued or exchanged.
But for a §1035 exchange, it is the date shown in the new
contract.
Cash distributions include forceouts, dividends, and
withdrawals, but do not include loans or amounts returned
(¶6/2) to preserve the §7702 or §7702A status of
the contract.
A benefit reduction is any decrease either in the death benefit
or in any QAB benefit below the level assumed on the issue date.
A cash distribution accompanies a benefit
reduction if it occurs on the same date as the reduction or
within the preceding two
years[18].

12 The amount subject to LIFO taxation due to benefit
reductions in the first fifteen years is the actual cash
distribution,
limited to a so-called “recapture ceiling” that may be
thought of as the excess of actual CSV before the reduction,
over allowable CSV after the reduction.
The recapture ceiling is thus in the nature of a forceout amount,
except that funds are not necessarily forced out of the contract.
If the benefit reduction occurs during the first five policy
years, the recapture ceiling for a CVAT contract is the
excess of CSV immediately before the reduction over NSP
immediately after the reduction.
If the benefit reduction
occurs during the first five policy years, the recapture
ceiling for a GPT contract is the excess of CSV immediately
before the reduction over corridor cash value (DB times
corridor factor) immediately after the reduction; or the
excess of premiums paid immediately before the reduction over
the guideline limit immediately after the reduction:
whichever is more restrictive.
If the benefit reduction
occurs after the first five years but during the first
fifteen years, then the recapture ceiling is the excess of
CSV over corridor cash value using GPT corridor factors for
both GPT and CVAT contracts.
If the recapture ceiling is
zero or negative, then no adverse taxation applies.
An admin system that doesn’t actually perform tax reporting
must nevertheless flag such reductions for manual attention.
The recapture ceiling is irrelevant to a MEC.

13 Unilateral changes the insurer makes in current interest,
mortality, expense, or
QAB[19]
rates are neither adjustment events
nor material changes; they are reflected immediately in the
CVAT DCV, but otherwise only when an adjustment event or
material change later occurs, and only with prospective
effect in either case.
Changes in rate class that are initiated by the
owner[20]
(such as smoker-to-nonsmoker changes
and reductions in substandard table ratings or flat extras)
are adjustment events and material changes to the extent
they affect §7702 and §7702A calculations, respectively;
typically, such changes are subject to underwriting and
affect guaranteed as well as current charges.

14 For §7702 and §7702A purposes, a substitution of insured
is treated as a taxable
exchange[21]
rather than an
adjustment[22].
A new contract is deemed to be issued.
Any value in the old contract is taxed as a full surrender, and
the remainder is rolled into the new contract.
The effective date of the new contract is deemed
to be the effective date of the exchange.
However, a substitution performed under a binding obligation in
the contract does not disturb grandfathering or restart the
fifteen-year clock (¶15/12).

6 Premiums, withdrawals, and forceouts

1 For §7702 purposes, premiums paid are all payments—no
matter who pays them—less forceouts, nontaxable
withdrawals[23],
amounts returned under ¶6/2, and charges for non-qualified
additional benefits that are not deducted from AV.
However, amounts the insurer pays into the contract under a
waiver benefit are
excluded[24].

2 Amounts returned in order to preserve the §7702
qualification[25]
of the contract reduce premiums paid, as long
as they are returned with taxable interest within sixty days
of the end of the policy year of payment.
Amounts returned in like manner to prevent a MEC under
§7702A[26]
are treated
the same way, because they are in the nature of forceouts.
The interest that is obligatorily added to such amounts does
not reduce premiums paid.

3 No admin system should accept any premium (or process any
other transaction) that makes a contract a
MEC[27]
without the owner’s prior consent.
No system—not even an illustration system—should
ever accept any premium that violates the guideline limit; the
great majority of vendor admin systems refuse to, and so does
lmi.
The alternative of accepting premium
unconditionally and processing a countervailing transaction
later is unreliable.
Across the industry, many MEC failures
have resulted from reliance on this alternative, when the
countervailing transaction is not processed in time.

4 If a post-issue change reduces the guideline limit below
cumulative premiums paid, the excess is forced out of the
contract.
Any such distribution is subject to the normal rules of
taxation[28],
particularly including those described
in ¶5/11–12.
A forceout is otherwise similar to a withdrawal
transaction except that it is not subject to any fees or
limits that apply to voluntary withdrawals.
Customarily, withdrawals reduce the SA, but forceouts do not.
If a forceout reduces the amount of premium considered under
the terms of an ROP benefit, then a cyclical formula results.
This can be resolved by applying the formula repeatedly until it
yields no further forceout of even a fraction of a
cent[29].

5 Products for the high net worth market typically require
involuntary
withdrawals[30]
(with no fee and no effect on SA) to keep NAAR constant when it
would otherwise increase beyond reinsurance capacity due to cash
value growth.
This is neither a taxable event under
§7702(f)(7)(B–E), nor an adjustment event, nor a
material change.
It’s like the payout of a dividend: instead of putting the
increment into the cash value, we mail it to the owner.

6 When a withdrawal decreases the SA, that decrease is an
adjustment event if the DB also changes.
Any transaction fee charged on a withdrawal is deducted from the
CVAT DCV, but is not included in the expense charges that enter
the guideline premium calculation; however, to the extent that it
decreases the SA, it flows into the adjustment event calculation.
Insofar as such a fee is part of the withdrawal, it reduces
basis, §7702 premiums paid, and §7702A amounts paid.

7 The GPT always permits payment of the minimum premium
required to keep a contract in force until the end of any
contract year, even if it would exceed the guideline premium
limit, as long as the CSV (ignoring any surrender charges or
loans) will be zero at the end of that
year[31].
To obviate the
premium solve this implies, admin systems ought instead to
calculate each month the least amount that will prevent the
contract from lapsing before the next
monthiversary[32].

7 Interest

1 Product specifications must always state guideline premium
interest assumptions.
The remainder of this section
describes how these assumptions are determined, and may be
skipped by programmers.

2 §7702 prescribes the interest basis for all §7702 and
§7702A calculations as the interest rate actually guaranteed
in the contract, or a statutory rate if greater.
The statutory rate is 4% for GLP and 6% for GSP.
It is 4% for
all CVAT and §7702A calculations, except that the necessary
premium for guideline contracts is defined in terms of the
guideline limit.

3 The §7702 net rate is determined in two steps.
First, the
guaranteed interest rate is determined from the contract,
and the statutory rate is used instead if it is greater.
This operation is performed separately for all periods with
different guaranteed
rates[33].
For example, if the guaranteed
rate is 4.5% for five years and 3.5% thereafter, then the
GLP interest rate is 4.5% for five years and 4.0%
thereafter, while the GSP rate is always 6.0%.
For products
such as pure variable UL that offer no explicit guarantee,
the statutory rate is used.
For variable products that offer
a general-account option, the guaranteed gross rate must be
no less than the general-account guaranteed rate.

4 Even short-term guarantees at issue must be reflected in
the GSP, the CVAT NSP, and the §7702A NSP, seven-pay
premium, and DCV.
They may be ignored as de minimis in calculating the §7702
GLP[34],
but only as long as they last no longer than one year.
Only guarantees that either last
longer than one year or are present on the issue date are
taken into account: a guarantee subsequently added for a
future period lasting no longer than one year is a dividend,
not an adjustment event.
Here, “issue” excludes cases where
the contract is merely deemed by statute to be
reissued[35].

5 Second, any current asset-based charges specified in the
contract are deducted if we wish.
The interest rate remains
what it is; the net rate that results from subtracting
asset-based charges is merely a computational convenience that
simplifies the formulas.
In fact, the full interest rate (never less than statutory) is
credited, and then asset-based charges are subtracted from the
account value.
Therefore, this adjustment affects only the §7702 guideline
premiums and the §7702 DCV, because those quantities reflect
expenses.
It must not be taken into account when calculating
the §7702 CVAT NSP or CVAT corridor factors, or the §7702A
NSP or seven-pay premium, because those quantities do not
reflect expenses.

6 Asset based charges can be deducted only if they are
specified in the contract itself: charges imposed by
separate accounts cannot be deducted unless they are
specified in the life insurance contract proper, since any
charge not so specified is deemed to be
zero[36].
They also must not exceed the charges reasonably expected to be
actually
imposed[37].
If the schedule page announces a charge
of “up to 100 basis points” and we actually charge 50 bp and
expect to keep charging that, then we can use 50 bp; but if
we ever charge less than 50 bp, an adjustment event results.

7 It is critical that the result be rounded up if at all,
and never rounded down or truncated.
The GPT is a
bright-line test, and truncation at, say, eight decimal places
may have an effect of more than a dollar per
thousand[38]
at a later duration.
Special attention must be paid to the exact
method the administration system uses (e.g. beginning of
period versus end of period), to be sure that the resulting
charge is what will actually be imposed.
A §7702(f)(8)
waiver granted in one actual case that was pennies over the
limit cost tens of thousands of dollars in filing and
attorney’s fees.

8 Thus, an account value load that is deducted from the
account value at the beginning of each month, before
interest is credited, may be reflected in GPT calculations.
We could calculate it as a monthly load in order to follow
the precise contract mechanics, but that would require a
significant modification of Eckley’s formulas, which do not
contemplate a load on AV.
Instead, we net the account value
load against the §7702 interest rate; as explained in ¶7/5,
this is a mere computational convenience that does not
change the actual interest rate.
A proof that this
alternative is conservative is given in the Actuarial
Addendum (¶B/8).

9 On the other hand, it is not clear that a classical mortality
and expense charge (M&E) can be reflected, because it is part
of the daily unit
value[39]
calculation.
The effect of this M&E on monthly interest is a function of
the ratio of successive unit values, and the actual charge
approaches zero when the unit values decrease quickly.
If a definite charge were clearly and unconditionally deducted at
the beginning of each day, before crediting interest, then we
might take it into account by adding daily commutation functions
to the Formulas section and extending the proof in ¶B/8
accordingly; but lmi ignores such charges.

10 Multiple guaranteed rates may result, for instance in the
case of a variable contract with a general-account option
and a distinct guarantee for loaned funds.
The highest such rate is used, because that produces the most
conservative guideline premium limits.

11 A higher rate guaranteed in a side letter must be
reflected as in ¶7/4, as though it were written in the
contract.
For products that guarantee a rate tied to an
index, the §7702 interest rates in the first guarantee
period must be at least as high as the rate determined by
the index when the contract is issued.
Such guarantees must
be taken into account even if they arise indirectly or
contingently, for instance in the case of an unloaned
credited rate that is guaranteed to be no less than 50 bp
below an indexed loan rate.
lmi performs no such initial-guarantee calculations.

12 For calculating mortality charges, most UL products
discount the NAAR for one month’s interest at a rate
specified in the contract.
§7702 and §7702A calculations
must use the §7702 rate instead whenever that is higher than
the contractual rate.
This affects all premium rates and
also the CVAT DCV and corridor factors.
Whenever this rate
is converted to a monthly equivalent, the result must be
rounded up if at all.
If the contract specifies no such
discount and none is actually applied, then a discount rate
of zero may be used.

13 The interest rate guaranteed by the contract is the
greater at each duration of the guaranteed loan credited
rate or the rate otherwise guaranteed.
If a fixed rate is
elected, then the guaranteed loan credited rate, if not
stated explicitly, is the fixed rate charged on loans minus
the guaranteed loan spread if any.
If the contract
guarantees neither the loan credited rate nor the loan
spread, then a fixed loan rate has no §7702 or §7702A
effect.

14 There is a concern if a variable loan rate (VLR) is elected.
Section 3.D of the VLR model regulation provides
that “the maximum rate…must be determined at regular
intervals at least once every twelve (12) months, but not
more frequently than once in any three-month period”. There
is no rate guarantee after the first anniversary, because
the VLR rate may change by that time.
However, since the
maximum VLR is fixed for at least three months at issue,
there is a short-term guarantee that must be reflected as in
¶7/4 if the rate actually credited on loans is too high.
The complications that ensue may be avoided by actually
crediting a loan rate no higher than §7702 otherwise
requires during the first loan rate determination period, or
simply by forbidding loans during that period.

8 Mortality

1 Product specifications must always state §7702
mortality assumptions.
The remainder of this section
describes how these assumptions are determined, and may be
skipped by programmers.
The Actuarial Addendum (¶B/9) addresses the conversion of
annual mortality rates to monthly.

2 §7702 prescribes the use of reasonable mortality that does
not exceed the charges the insurer actually expects to
impose, except for the safe harbor that IRS Notice 2006-95
provides.
The mortality tables specified in the safe harbor
vary by gender (except that unisex rates may be used for
females, but only where required by state
law[40])
and, if prescribed in the contract, by tobacco use.

3 For insureds with no table rating, lmi uses guaranteed
mortality, limited to 100% of safe-harbor mortality at each
duration.
The 100% limit applies even if the guaranteed
mortality is greater (as for some guaranteed-issue and
simplified-issue contracts).
lmi does not support contracts
that guarantee mortality lower than the safe
harbor[41].

4 For insureds with a substandard table rating, we may
compare current mortality reflecting the rating to 100% of
safe-harbor mortality, and use the greater of these two
values in each year.
We may choose to ignore ratings due to foreign residence.
We may indeed choose to use 100% of
safe-harbor mortality in all cases as an administrative
simplification, in which case changes in table ratings or
flat extras are not adjustment events; that is the only
option lmi currently supports.
As a consequence, a contract
may lapse early even though the CVAT NSP is paid as a single
premium, the seven-pay premium is paid annually for the
first seven years, or the GLP is paid annually forever.

5 Any flat extras may be added to the mortality rates for
all applicable durations, provided that we actually expect
to impose the total charge that results (as for table
ratings, above).
However, for the GLP, it may be better to
add any temporary flat extra as an explicit charge in every
applicable year, in order to avoid an adjustment event when
the flat expires or is reduced or forgiven.
This follows the
Blue Book discussion of QABs; even though a flat extra
doesn’t otherwise look like a QAB, it’s a reasonable thing
to do for a temporary flat.
But this approach gives no
relief for flat extras that are permanent: an adjustment
event occurs if they are later reduced or forgiven.

6 At any rate, it is probably better to ignore flat extras
altogether for calculating UL §7702 and §7702A limits;
that is what lmi does.
Flat extras normally flow through the AV,
and IRS has expressed concern that they may therefore earn
tax-advantaged interest.
While we realize that flat extras
increase the premiums necessary to achieve a given AV, it is
not transparent to IRS that they make the contract less
investment oriented.

7 Some policy forms “blend” mortality by gender or tobacco
use, specifying (at issue, and immutably unless there is a
misstatement of age or gender) the applicable safe-harbor
mortality tables.
Their treatment of current mortality may
pose daunting practical problems if it is desired to reflect
substandard ratings in §7702 and §7702A calculations,
for example if the blending percentages for current mortality
are revised periodically to reflect case demographic changes.
We have seen a contract that blends mortality by
interpolating on qx instead of
tpx,
and IRS might assert
that this departure from generally accepted actuarial
practice ignores the expected improvement over time as the
proportion of nonsmokers and females increases.
At best, any use of blended current mortality could be expected
to produce unwelcome adjustment events.
It does not affect any
§7702 or §7702A calculation unless substandard mortality is
reflected, so substandard mortality should certainly be
ignored for such contracts.

9 Expense charges

1 Current expense charges that the insurer actually expects
to impose are reflected in guideline premiums and the CVAT DCV.
Higher guaranteed charges are disregarded.
Originally,
guaranteed charges were allowed, but the statute was changed in
1988[42]
due to perceived abuses.
Expense charges are
ignored for the CVAT net single premium and for the net
single and seven-pay premiums used for MEC testing.
However, they are always taken into account for necessary premium
calculations.
Furthermore, charges for
QABs[43]
may always be reflected in all calculations.

2 For products with charges that are tiered by premium or by
total assets
(which can change on every valuation date), it is convenient
to select a charge amount low enough that it will never need
to be changed, or conservatively to disregard the charge
altogether[44].
lmi applies the lowest current tiered rate (cf.
¶7/6) for all guideline premium calculations, but uses the
actual current charge for the CVAT DCV.

3 Some products pass the actual premium tax through as a
load; it’s treated like any other load.
If the insurer
adapts it to changes in premium-tax rates, that’s
treated like any other unilateral change (¶5/13).

4 To account for the possibility that current expense
charges have changed, the admin system must provide the
current GLP and GSP to the inforce illustration system.

10 Secondary cash value guarantees

1 For products with a secondary cash value guarantee, the
§7702 interest, mortality, and (if applicable) expense basis
at each duration must be at least as conservative as the
basis that actually determines the guaranteed value at each
duration[45].
An exact calculation must be done for each month
and for each possible combination of issue age, underwriting
class, and so
on[46].
The practical difficulty of these calculations might be mitigated
by using the more conservative basis for all durations, and by
using the CVAT instead of the
GPT[47].

2 Consider a product that is guaranteed to remain in force with a
CSV of at least zero as long as the GLP is paid each year.
This guarantee may be disregarded under §7702 to the
extent that the guarantee premium exactly equals the GLP;
but if it is calculated in any other
way[48],
then ¶10/1
applies, requiring potentially onerous calculations.

11 Riders

1 Riders and other additional benefits are either
“qualified” or not.
QABs receive more favorable treatment (¶11/2–7), which
extends to CVAT NSP and
corridor factors, and to §7702A NSP, DCV, and seven-pay
premiums, as well as to guideline premiums, except where
specifically noted otherwise.
Currently, lmi does not treat
any eligible additional benefit as a QAB, but it does
support the term rider described in ¶11/8.

2 QABs can be prefunded through the AV.
A QAB’s benefit is
deemed to be the stream of current charges for the QAB, but
only over the period during which such charges are payable
as established in the
contract[49].
Thus, the QAB’s charges
create a level positive increment to the guideline premiums
for that charge period, with appropriate effects on the
other quantities in ¶11/1.
At the end of that period, the
increment goes away, even if the QAB’s benefits continue;
this is neither an adjustment event, nor a material change,
nor a §7702A(c)(2)(A) decrease in
benefits[50].
Thus, QABs may
not be funded through contract maturity unless their charges
continue through maturity.

3 Both benefits and charges for non-qualified additional
benefits are completely disregarded if their charges cannot
flow through the AV, in which case the charges are paid in
cash and do not count as
premium[51].
Otherwise, payments
to support them count against the premium limit, and their
charges decrease the AV (and, hence, the CSV and corridor
DB) without directly increasing any payment limit—although
they do decrease the
DCV[52].
That outcome can be avoided by
stipulating that the charges must be paid in cash and cannot
be deducted from the AV.
At any rate, no change in a
non-qualified additional benefit is an adjustment event, a
material change, or a §7702A(c)(2)(A)
decrease[53].

4 Only the following are QABs according to §7702(f)(5)(A)
(but see ¶11/5):
guaranteed insurability,
accidental death or disability benefit,
spouse and child term riders,
disability waiver benefit, or
other benefits prescribed under regulations (of which there are none).
The seven-pay premium calculation disregards any QAB whose
benefits last fewer than seven years.
Otherwise, that calculation can include a QAB’s charges for
the period those charges continue, even if that is less than
seven years.

5 A term rider on the main insured whose benefit terminates
prior to age 95 is treated as a QAB for §7702, but as death
benefit for §7702A unless it expires within the first seven
contract years.
If the benefit is guaranteed at least until
age 95, then it is treated as death benefit for both §7702
and §7702A.
Death-benefit treatment is the most favorable
outcome: it values the benefit using §7702 mortality rather
than current rider charges.
For a term rider treated as
death benefit, §7702 calculations reflect the actual benefit
duration, but §7702A calculations deem the benefit to last until
maturity[54].

6 Increasing or decreasing the benefit amount of a QAB (such
as a term rider) is an adjustment event.
Terminating a QAB
is an adjustment event and a §7702A(c)(2)(A) decrease,
whether the termination is elective or required by the terms
of the contract; but expiry at a date set in the contract at
issue is not (¶11/2).
In particular, there is an adjustment
event when a spouse or child term rider terminates due to their
death[55],
but not when such a term rider terminates due
to the family member’s attainment of a specified expiry
age[56].
Revising or removing a rating on a QAB (for example, an
occupational accidental death rating) is an adjustment event
unless the rating was disregarded in §7702 calculations.
Neither disability, nor recovery therefrom, is an adjustment
event for a waiver benefit.

7 A rider that waives monthly deductions (as opposed to
paying a stipulated premium), with a charge proportional to
the actual monthly deduction, poses a definitional difficulty.
The charge for the benefit is indeterminate
because AV growth generally changes the NAAR and hence the
mortality charges.
In theory the waiver charge attributable
to determinate amounts such as the policy fee or load per $1
of SA could be reflected.
But those amounts are probably
almost negligible, so it is better to treat such a waiver
benefit as a non-qualified additional benefit—which is what
lmi does.

8 Consider an “integrated” term rider that
automatically adjusts to offset the corridor and automatically
converts to the base contract at, say, age 70.
While it is in force, its DB is the term SA minus the portion of
the base policy DB due solely to the corridor, but never less
than zero.
This rider is appropriately treated as death
benefit, ¶11/5 notwithstanding, and not as a QAB because the
automatic conversion preserves the total DB with no action
on the owner’s part and a positive election is required to
obtain any different
outcome[57].
Termination of this rider, e.g.
because there is insufficient AV to pay its monthly cost,
is an adjustment event and a §7702A(c)(2)(A) decrease,
unless its DB simultaneously converts to the base.

12 Product-design opportunities and pitfalls

1 Product designs that impute an addition to AV when
calculating the corridor DB should address the concerns
described in ¶4/1, preferably in such a way that the add-on
amount does not change when an adjustment event, material
change, or decrease occurs.

2 Pursuant to the discussion of ROP above (¶4/6), a modified
ROP death benefit option might provide for the greater of
the usual ROP death benefit and the option B death benefit.
With this option, we could calculate GLP (but not GSP) on an
option B basis, perhaps tripling the GLP that would
otherwise apply.
However, in durations where the option B
death benefit governs, higher death benefits and COI charges
would result.

3 When interest rate guarantees are added after a contract
is issued, it is preferable to limit them to one year.
Otherwise, they adversely affect the interest rate used for
calculating the GLP (¶7/4).

4 If it is desired to reflect account value loads (such as
M&E charges) in guideline premium calculations, then it is
important to specify and implement them in such a way that
they can legitimately increase the guideline premiums
(¶7/8–9).

5 During the first VLR rate determination period, VLR
contracts should avoid short-term guarantees by either
forbidding loans or crediting loan interest at the §7702
rate (¶7/14).

6 Consideration might be given to moving flat extras outside
the AV, by billing for them and requiring them to be paid
directly on a current basis.
This should remove any IRS
concern that they could be prefunded, thus making it safe to
reflect them in guideline premium calculations (¶8/6).
Flat extras are particularly important for certain survivorship
product designs.

7 §7702 (f)(5)(C)(ii) allows us to exclude the charges for
non-qualified additional benefits from premiums paid, so
that they do not count against the guideline limit, if they
are “not prefunded”.
The only way to preclude prefunding is
to prevent the charges for these benefits from flowing
through the AV by requiring them to be paid in cash (¶11/3).
It may be beneficial to structure such benefits that way.

8 Term riders that are not “integrated” with the base policy
for §7702 purposes (¶11/8) receive more favorable treatment
if they last at least until age 95.
On the other hand, New
York has non-extraterritorial rules that make it difficult
to continue a term rider past age 70, and even more
difficult past age 80, in that state.
Consider extending term riders to the base contract’s
maturity age outside New York.

13 MEC testing

1 The choice of §7702 test affects MEC testing under §7702A.
The latter section inherits definitions and calculation
rules from the former; they ought to be consistent for each
definitional test.
An event-driven algorithm for MEC testing is given in Addendum A.

2 MEC testing can be simpler for GPT than for CVAT contracts.
It is advantageous to make the necessary-premium
and guideline-premium limits identical so that the former
need not be calculated separately: then no unnecessary
premium can be paid without failing the definitional
test[58].
To this end, the server offers two different methods.
In order to avoid certain difficulties that might otherwise
occur[59],
the first method
treats every adjustment event as a material change, and
therefore applies both the rollover rule and the reduction
rule to decrease
adjustments[60].
The second method simply
assumes that such difficulties do not arise; it treats
adjustment events as reductions when they decrease benefits,
and as material changes otherwise.

3 Decreases are subject to retrospective seven-pay testing,
whether or not an adjustment event has occurred.
Premature
termination[61]
of a QAB is treated as a decrease.

4 A material change resets the “contract year” so that it
might not coincide with any policy year.
Underwriting procedures should guard against abuse such as a
series of trivial changes on successive
days[62].

14 Formulas

1 The determination of guideline premiums requires a
considerable amount of floating point calculations.
It is important to minimize the cost of these calculations in the
case of systems that administer a great number of contracts,
or illustration systems that are judged on their speed.

2 Commutation functions as defined by Eckley [TSA XXXIX,
page 19] are used in order to perform the calculations
rapidly while following the actual mechanics of a UL contract.
This implementation trades perfection for speed by
conservatively ignoring the corridor.
It appears that this
affects only the GLP for DBO B, which could be increased
somewhat at a significant expense in complexity and run time.

14.1 Product parameters

1 The following monthly effective rates must be specified in
product-specific addenda; they are level within any policy
year.

3 Variables with no subscript need not be saved across
iterations.
The variable
aDt
has a value at the maturity duration so that it can be used to
discount the endowment benefit payable at the end of that year;
other vector variables are shorter by one.

4 Recalculation after issue can be obviated by calculating
Ct and
Dt
for all durations and storing the results for both DBO A and B.
They cannot change after issue unless the mortality or interest
basis changes.

14.3 Guideline premiums

1 GSP calculations always use DBO A commutation functions.
GLP calculations use commutation functions for the DBO in
effect (for ROP, see ¶4/6).

A Addendum: MEC testing

Important definitions

“Contract year” does not always mean policy year.
Policy year is one plus the number of full years since issue.
Contract year is one plus the number of full years since the
last material change, or since issue if there has been no
material change.
Contract year restarts at one on the date of any material change,
which may not be a policy anniversary.

Least death benefit (LDB) is the lowest death benefit
(including any QABs) in the most recent seven-year test
period[63].

Other terms (e.g., CSV) are as defined in our GPT specifications.

When a contract is issued

Calculate the seven-pay premium as
7Px × DB + amortized QAB charges[64]
using the initial DB defined in our GPT
specifications[65].
Round it down if at all.

Start a new seven-year test period on the day of issue.

Record the initial death benefit as the LDB.

For CVAT contracts, set DCV to zero before recognizing the
initial premium or any §1035 exchange.

When a §1035 exchange occurs

A new life insurance contract is a MEC if it is issued as a
§1035 exchange from a MEC.

A §1035 exchange, while technically a material change,
receives special handling.
Process all §1035 exchanges before any other payment.
At issue, treat the anticipated
exchange amount, net of all premium-based loads including
any premium-tax load, as a non-premium increment to CSV.
For CVAT contracts, increase DCV by this increment.
Do not test this increment against the seven-pay premium.
Recalculate the seven-pay premium with the formula
7Px+t × (DB − CSV ÷ Ax+t) + amortized QAB charges
used for material changes, with t naturally equal to zero.
Test for unnecessary
premium[66].

When the exchanged funds are ultimately received, reissue
the policy reflecting the actual §1035
amount[67],
and retest
from the original issue date.

When a premium is paid

During every seven-year test period, test each
“amount paid”[68]
(except any §1035 amount) against the
seven-pay premium limit.
The limit, measured on each day
during that period, is cumulative seven-pay premiums minus
cumulative amounts paid.
If any amount paid exceeds the limit, then the contract becomes a
MEC.
Otherwise, test for unnecessary premium.

Testing for unnecessary premium

Our GPT specifications ensure that no unnecessary premium can
ever be paid.
Skip the rest of this section for GPT contracts.
But perform these calculations for CVAT contracts:

NSP is the net single premium rate for the attained age
times LDB, plus the present value of QAB charges, reflecting
the benefit amount of each QAB in the first contract year.
Round it down if at all.

Necessary premium is NSP adjusted for the cash value.
Normally the adjustment equals DCV.
Whenever CSV is lower than DCV, use CSV
instead[69],
but don’t change DCV.
If the adjustment is less than zero, then use zero instead.
Thus:
Adjustment = max[0, min(DCV, CSV)]

Net necessary premium is NSP minus the adjustment for cash value.
Round it down if at all.
If the result is less than zero, then use zero instead.
Thus:
Net = max(0, NSP - Adjustment)

Gross necessary premium is net necessary premium adjusted
for premium-based load (PL) including any premium-tax load.
If PL is a scalar:
Gross = Net ÷ (1 − PL)
Sometimes PL is tiered such that one load PLTarget applies up
to target premium and a different load PLExcess on any excess.
In that case:
Gross = [Net + Breakpoint × (PLTarget − PLExcess)] ÷ (1 − PLExcess)
In either case, round the result down if at all.

Accept payments up to the gross necessary premium.
Any remaining payment is unnecessary premium.
If there is any unnecessary premium, process a material change
before accepting it.
The material change happens after the
necessary premium was applied to CSV and DB was updated if
necessary to reflect any corridor, ROP, or similar increase
due to necessary premium.

When monthiversary processing is performed

Update DCV for CVAT contracts.
Accumulate it like AV, but using §7702 assumptions.
Reflect the actual death benefit option.
Use current charges and
loads[70].
Use §7702 interest and mortality.
Reflect all transactions, but ignore
loans[71].
Disregard charges for nonqualified additional
benefits[72].
Add any extra amounts payable on surrender such as refundable
sales loads but do not accumulate those amounts at interest.
Round it up if at all.
Whenever it is negative, set it to zero.
Ignore this step for GPT contracts, which have no DCV.

When a material change occurs

Process material changes as of the very day they take
effect, and not as of any other
date[73].

Start a new seven-year test period on the day of the
material change, even if that is not a monthiversary.
§7702A treats the contract as though it were issued on that
day.

For CVAT contracts, set DCV equal to CSV immediately prior
to the material change.

Calculate a new seven-pay
premium[74]
as
7Px+t × (DB − CSV ÷ Ax+t) + amortized QAB charges
where CSV reflects all necessary premium paid, but no
unnecessary premium, and DB reflects the corridor factor
times this CSV and any ROP increase due to necessary
premium, as well as any increases.
Round it down if at all.

If the new seven-pay premium is negative, set it to zero.
In this case, the contract does not become a MEC, but no
premium can be paid for seven
years[75].

Record the values of CSV and DB for use in handling any
later decrease.

Test any unnecessary premium against the new seven-pay premium limit.
If it exceeds the limit, then the contract becomes a MEC.

When benefits decrease

Examine the death benefit and every QAB benefit each day to
see whether they decrease for any reason.
If neither the
death benefit nor any QAB benefit decreases below the level
originally assumed at the beginning of the most recent
seven-year test period, then skip this step.

For individual life and first-to-die contracts, skip this
step if the most recent seven-year test period has already ended.
But for survivorship contracts, proceed even if that
period has ended.

Update LDB and each QAB’s benefit amount to reflect
decreases
only[76].
If one of these items increases while
another one decreases, then process a material change and
skip the rest of this
step[77].

Calculate a new seven-pay premium as
7Px × (LDB − CSV ÷ Ax) + amortized QAB charges
LDB reflects the decrease.
CSV is as of the beginning of the
first contract year, and may often be zero.
The stream of QAB charges begins in the first contract year, and
its present value is as of the first contract year.
If the decrease occurs within the first seven policy years, then
CSV reflects any §1035 exchange.
If the new seven-pay premium is negative, set it to zero.
Round it down if at all.

Using the new seven-pay premium, retest each payment made
throughout the most recent seven-year test period.
Never look back before the latest material change.
Stop testing at the end of the seven-year period, even for
survivorship contracts.
If premium exceeds the new seven-pay limit at any time during the
retrospective seven-year test period, then the contract becomes a
MEC as of the current
date[78].

When a contract becomes a MEC

Notify all appropriate parties immediately.
The admin system ought to have prevented an inadvertent MEC
(¶6/3).

All or a portion of any payments can be returned within sixty
days after the end of the contract year in which they were paid.
It may be possible to return enough to prevent a MEC.
Subtract the payments returned, without interest, from
amounts paid, and redo the §7702A calculations using the
revised amount paid.
Return the payments to the owner with taxable interest.

Unless it is cured this way, once a contract is a MEC, it is
always a MEC.
IRS can cure it, but normally will not except
under a formal remediation program.
There is no other way to cure a MEC.
For instance, a retroactive change in specified
amount does not correct a MEC.

Whenever a contract becomes a MEC, apply less-favorable MEC
taxation to all distributions made within the preceding two
years (¶5/11), even though they were not so taxed when they
occurred.

Other material changes

Correction of a misstatement of age or gender is a material
change.
Consult the actuarial department when this occurs.
An irremediable MEC may
result[79].

Removing a substandard rating is a material change if the
rating was reflected in §7702A calculations.
So is a change from smoker to nonsmoker, if that distinction was
reflected in §7702A
calculations[80].

Any fundamental modification such as a change in the §7702
mortality or interest basis is a material change.
For substitution of insured, see ¶5/14.

Illustration strategies to avoid a MEC

Increasing SA whenever a MEC would otherwise occur is a feasible
if somewhat impractical illustration strategy when every SA
increase is recognized as a material change.
But when payment of unnecessary premium is the only
material-change trigger, that strategy no longer works very
well[81].
Unnecessary premium paid during a
seven-year test period typically violates the seven-pay
limit, producing a MEC.
This strategy is inefficient anyway:
it is generally much better to purchase a new policy.

Another common strategy reduces each successive premium as
required to satisfy the seven-pay test and avoid a MEC.
But paying the full input premium might increase AV when the
reduced premium would let AV decrease.
Thus, reducing the
premium on an option 2 contract can cause the DB to decrease
and trigger retrospective retesting that could produce a MEC.
That problem might be avoided by manually increasing SA
whenever necessary to avoid a decrease that would produce a MEC.

Furthermore, reducing each successive premium to the
seven-pay limit still allows unnecessary premium to be paid
outside a seven-year test period.
The ensuing series of
material changes might produce a stream of payments totaling
less than could be paid by avoiding unnecessary premium.

Notation

nPx+t
is the net n-pay premium per dollar of death benefit
for a life issued at age x at duration t, reflecting actual
monthiversary mechanics.

Ax+t is the net single premium per dollar of death benefit
for a life issued at age x at duration t, reflecting actual
monthiversary mechanics.

x is the insurance age as of the beginning of the first
contract year (which is not necessarily the first policy
year).

t is the number of full contract years since the
beginning of the most recent seven-year test period.
For example, if a contract was materially changed two years and
three months ago, then t is two today.
Wherever t occurs in this addendum’s
formulas, it always happens to have the value zero,
because the contract is deemed to be reissued upon material
change; it is written only to emphasize that the
insurance age as of the first contract year is meant.

B Actuarial addendum

1 This section discusses some technical issues and is
intended only for actuaries who desire a more detailed treatment.
Others may skip it.

2 The power of Eckley’s UL commutation technique is
inadequately appreciated.
It permits the calculation of any
isolated annual value without iteration in many important
cases[82].
Account values can be conveniently determined by
applying the prospective formula for terminal reserves.

3 I have calculated the account values associated with
guideline premiums (akin to a guaranteed maturity fund) in
lmi, computing values iteratively each month, and
compared them to results from a spreadsheet that uses monthly
commutation functions.
I selected issue age 20 so that the calculations would span many
years, and ran both systems to endowment at age 100 with the same
assumptions and no rounding.
The absolute value of the largest relative error
in AV in any year was 0.00000000012, or one hundred twenty
parts per trillion.
This discrepancy arises because of the way floating point numbers
are stored and manipulated by computer hardware.

4 One much coarser method uses classic annual curtate commutation
functions made approximately semicontinuous by an
i ⁄ δ adjustment.
It is not appropriate to apply such an adjustment to the formulas
in this monograph, because they already reflect the monthiversary
mechanics of a typical UL contract (but see ¶B/9 for an
adjustment to q that is appropriate).
At any rate, monthly functions are nearly equal to continuous:
for i = 4%,

i ⁄ i(n)

n

1.009901951

2

semiannual

1.014877439

4

quarterly

1.018203509

12

monthly

1.019814474

365

daily

1.019869268

∞

continuous

5 It would be a good idea to work the examples in
Desrochers’s paper (TSA XL) and compare and contrast our
results with his.

6 We ought to analyze the conservatism that results from
ignoring the corridor in guideline premium calculations,
particularly with respect to option B.

7 When calculating guideline premiums two ways—above and
below target premium—some practitioners always perform both
calculations and assume that the lower is the one that
should be used.
It would be interesting to know whether this is always correct.
But it does not seem to suggest any way to speed up our program.

8 Here is a proof of the assertion (¶7/8) that netting an
account value load against the §7702 interest rate is a
conservative alternative to reflecting the AV load exactly.
Assuming that the account value load is deducted before
other monthly charges, we have two cases:

It would of course be possible to generalize Eckley’s work
to reflect the load exactly, gaining a slight advantage at
the cost of much extra work.
The algebra would be complicated enough that questions might
arise as to its rigorous validity.
We prefer to use Eckley’s work as he
presents it, pointing out that we can accurately reproduce
the numerical examples in his paper.

If instead the account value load is deducted after other
monthly charges, then the validity of the assertion can seen
immediately: both Eckley’s equations (1) and (14) are of the
form
(AV+P−deductions)(1+ic)=1V
which, for a load s deducted after other charges, becomes
(AV+P−deductions)(1+ic)(1−s)=1V
and it is conservative to apply the net rate (1+ic−s)
because
1+ic−s < 1+ic−s−(s×ic) = (1+ic)(1−s)
where s and ic are both necessarily positive.

When the load (whether deducted before or after other
monthly charges) is netted against the interest rate in this
fashion, the annual effective rates are simply subtracted.
It is important to understand that we are not deducting the
spread from the statutory rate to produce a lower §7702
interest rate.
Rather, the §7702 interest rate remains what it is,
and we are netting the AV load against it as a conservative
mathematical simplification.

9 Tabular annual safe-harbor (¶8/2) mortality rates (q) may
be converted as follows for use as monthly effective rates
in ¶14.1/1.

C Template for product-specific addenda

Parameters for lmi’s “sample” product:

qc §7702 mortality rate:
1980 CSO converted as described in ¶B/9,
limited to 1⁄12
ic §7702 interest rate:
0.00327373978219891 in all years for GLP
0.00486755056534305 in all years for GSP
ig death-benefit discount rate: same as ic

[2]
The reasonableness of a termination dividend depends on
historical practice.
The legislative history cites New
York’s rules as an example and notes that termination
dividends have historically been modest: DEFRA Blue Book,
page 647.
In the 1990s, one company marketed a survivorship product with
a termination dividend on the order of $400 per thousand; that
would obviously be part of CSV for §7702 and §7702A.

[3]
Because, for instance, interest on dividend accumulations
is taxed when it accrues.
But the cash value of paid-up additions is included in CSV.

[5]
Except that a GPT contract can switch to the CVAT when a
nonforfeiture option is elected.
This may make a reduced paid-up benefit easier to implement,
although it may increase the amount of that benefit.

[6]
This is so even if the new contract is issued in exchange
for several old contracts, only one of which is a MEC.

[7]
DEFRA Blue Book, page 651.
But see footnote 57 on page
655: “The use of the date on the policy would not be
considered the date of issue if the period between the date
of application and the date on which the policy is actually
placed in force is substantially longer than under the
company’s usual business practice.”

[8]
While the legislative history refers to the end of the
mortality table, the statute literally says age 100, so age
100 applies even to the 2001 CSO table, which extends to age
121.

[10]
With respect to MEC testing only; §7702A(c)(2)(A) has no
effect on the definitional test.
For example, an experience-rated group policy might apportion its
experience reserve across certificates according to their most
recent yearly COI deductions, which affects the amount of the
deductions; but a decrease does not change historical deductions.
Or consider a contract with a sales load refund equal to some
percentage of commissions.
That calculation would be
different if the policy were reissued, even though
commissions aren’t drawn back when §7702A(c)(2)(A) deems the
contract to be reissued at a lower benefit.
Therefore, a reduction during the sales load refund period may
create a retrospective MEC.

[12]
Table-driven systems normally disregard this adjustment,
as lmi currently does, yet it is explicitly permitted by
the DEFRA Blue Book, page 649: “Finally, the amount of any
qualified additional benefits will not be taken into account
in determining the net single premium.
However, the charge
stated in the contract for the qualified additional benefit
will be treated as a future benefit, thereby increasing the
cash value limitation by the discounted value of that
charge.”

[13]
§7702(e)(1)(D) permits treating a UL contract’s cash value
at maturity as an endowment benefit, up to the “least amount
payable as a death benefit at any time under the contract”.
This means that NSP is not simply Ax, but rather
Ax:angle(100−x): not Mx ⁄ Dx, but rather (Mx + D100) ⁄ Dx.
The purpose of the computational rule is to forbid any
coefficient higher than unity on the D100 term.
Thus, IRS
Notice 2009-47, section 3.02(b), says that NSP calculations
under the 2001 CSO “would assume an endowment on the date
the insured attains age 100”. The DEFRA Blue Book, at page
652, says that 7702(e)(1)(B) “will generally prevent
contracts endowing at face value before age 95 from
qualifying as life insurance”; it specifically does not rule
out contracts that endow later for an amount no higher than
“face value”.
For contracts that have undergone benefit
changes, this amount must be adjusted.
Page 653 says that
for CVAT contracts, it “must be computed treating the date
of change, in effect, as a new date of issue”; for GPT
contracts, “the date of change for increased benefits should
be treated as a new date only with respect to the changed
portion of the contract”—i.e., B in the
A + B − C
formula—so
that A, B, and C all apply their respective benefit amounts
to D100 as they do to Mx.
This is what DesRochers’s paper in
TSA XL does, e.g. on pages 240 and 262–263.
The endowment
amount is limited, as in ¶3/1, to the specified amount.
(It’s okay if ¶5/5 happens to overstate the endowment amount
for C, because that is a subtractive term.)

[14]
Some contracts change the death benefit to what would have
been purchased by the actual premiums paid at the correct age
and gender: the intention is to satisfy the Code, although
the required recalculation may be difficult.
Other contracts
take the ratio of what the most recent monthly deduction
should have been to what it actually was, and multiply the
death benefit by that; the intention is to simplify the
calculation, and a likely result is an irremediably failed
contract.
Many contracts have an overriding provision empowering the
company to do anything necessary to reform the contract so as to
comply with §7702 (but less often §7702A).

[15]
This appears unlikely but is not impossible.
For instance, a sufficiently large policy fee might cause the GSP
to exceed the reciprocal of the corridor factor.
Even so, we would ignore the corridor increase in determining old
and new DB for purposes of this paragraph.

[16]
The legislative history supports not treating any such DB
increase as an adjustment event anyway.
DEFRA Blue Book,
page 654: “no adjustment shall be made if the change occurs
automatically, for example, a change due to…the payment of
guideline premiums or changes initiated by the company.”

[17]
Forceouts are not limited to premiums paid: income can be
forced out as well.

[18]
730 days; 731 if an intercalary day is comprised.
Some would look back only to the beginning of the current
calendar year, arguing that regulations implementing the
two-year lookback of §7702(f)(7)(E) and §7702A(d)(2)
have never been issued.

[19]
OBRA House Report, page 1438: “an increase in the charge
for a qualified additional benefit is not a material
change…. An addition of, or an increase in, a qualified
additional benefit, however, is a material change”. The
legislative history does not address decreases in a scale of
QAB charges.
Ignoring them is consonant with the apparent intent.

[20]
128 Cong. Rec. S10943, 1982-08-19: “Such adjustments are
only to be made in two situations: First, if the change
represents a previously scheduled benefit increase that was
not reflected in the guideline premiums because of the
so-called computational rules; or second, if the change is
initiated by the policy over [owner] to alter the amount or
pattern of the benefits.” See also OBRA House Report, page
1438.

[21]
“If a life insurance policy provides the policyholder with
an option to change the insured, the exercise of the option
is a sale or other disposition under section 1001 of the
Code and section 1035 does not apply….
Section 1.1035-1 of
the regulations expressly excludes from the application of
section 1035 exchanges of policies that do not relate to the
same insured and thus prevents policy owners from deferring
indefinitely recognition of gain with respect to the policy
value.” Rev. Rul. 90-109.

[22]
Some might treat a substitution of insured as both an
adjustment event and a material change, relying on the DEFRA
Blue Book, page 656: “A substitution of insured…pursuant to
a binding obligation will not be considered to create a new
contract”.
However, IRS would more likely enforce Rev. Rul. 90-109.

[23]
Withdrawals are generally nontaxable up to basis under
§72(e) unless the contract is a MEC.
But see §7702(f)(7)(B–E).
The server assumes that its client
distinguishes taxable from nontaxable withdrawals.

[24]
PLR 9106050: “A waiver of the monthly deduction under the
disability waiver rider does not affect Taxpayer’s
‘investment in the contract’ under section 72(e)(6) of the
Code or the ‘premiums paid’ under section 7702(f)(1)(A) for
the Contract.” Andrew Strelka’s “Taxing the Disabled” in the
Spring 2007 issue of Richmond Journal of Law and the Public
Interest discusses this matter in depth.

[27]
It may be impossible to avoid a MEC in extraordinary
circumstances (e.g., misstatement of age) or pathological cases
(e.g., an investment return approaching −100% on a VUL
contract with a negative seven-pay premium).

[28]
The DEFRA Blue Book, page 654, says that such a
“distribution will be taxable to the policyholder as
ordinary income to the extent there is income in the
contract.” The 1986 statute changed that
(§7702(f)(7)(B–E)).
Often, a forceout is a tax-free return of premium.

[29]
Convergence of the resulting series could be hastened by
conservatively adding one cent to each forceout iterand.
Alternatively, the geometric series theorem could be applied.
The server does not do this because it is desired
that the client perform the forceout calculation.

[30]
We call these “involuntary withdrawals” to
distinguish them from the “forceouts” of ¶6/4.
The concepts are somewhat similar, but their treatment under
§7702(f)(7)(B–E) differs.

[38]
This would not be a “reasonable” approximation: DEFRA Blue
Book, page 653.

[39]
In all likelihood, unit values reflect quarterly fund expenses
that are applied to average assets in a way that varies from one
fund to the next, and such expenses aren’t specified in the
contract (¶7/6).

[40]
And also in Norris cases, where state law must be read to
conform to Title VII of the Civil Rights Act of 1964.

[41]
Guaranteed mortality lower than the safe harbor might
raise state approval issues, for instance in the area of
nonforfeiture.

[42]
Public Law 100-647 of 1988 (TAMRA) amended
§7702(c)(3)(B)(ii), which formerly permitted
“any charges…specified in the contract”,
to allow only “reasonable charges…reasonably
expected to be actually paid”.

[44]
Asset-tiered charges could be reflected exactly at the
cost of extra complexity.
Ignoring them is safe even under
the old-fashioned interpretation that any change in current
charges is an adjustment event.

[46]
This exhaustive approach is not necessary if a formulaic
approach suffices to cover every possible case.

[47]
Alternatively, Desrochers [Transactions of the Society of
Actuaries (TSA) XL, page 209] suggests setting a load equal
to the difference between the GLP and the nonforfeiture
premium.
But the rules on reasonable charges that came after
that paper was published rendered this approach of little or
no practical applicability.

[48]
For instance, by using an approximate calculation such as
a table lookup, or by using a different mortality table.

[49]
A MEC testing server will need to know the maximum funding
duration and maximum benefit duration for each QAB.

[50]
Neither is there any such consequence if a QAB is
terminated, or its benefits increased or decreased, after
the funding period, as long as the current charges remain
zero.
One could imagine a QAB term rider, fundable over a
shorter term than its benefits last, whose benefit is
conditionally reduced whenever poor investment performance
would cause NAAR to increase beyond reinsurance capacity, in
a context similar to ¶6/5.

[52]
Charges for a non-QAB are treated as any other amount
deducted from a contract: they’re potentially taxable.
Consider a single-premium life contract with a long term
care benefit funded by withdrawals.
The withdrawals generate taxable income, just as if the base
policy and the non-QAB were separate entities.

[53]
A non-qualified additional benefit is not a benefit at all
under §7702(f)(5)(C)(i).

[54]
Perhaps this means that the endowment benefit (¶4/7) could
include the term amount for §7702A only, but we disregard
that reading.

[55]
TEFRA Blue Book, page 371: “the guideline premiums are to
be adjusted…if a qualified additional benefit ceases for any
reason, including the death of an individual (such as the
insured’s spouse) insured thereunder, this is considered a
change in benefits requiring an adjustment of the guideline
premiums.” Thus, if a family member covered under a QAB dies
within the first seven contract years, and the full
seven-pay premium reflecting the QAB has been paid each year, then
the death triggers a §7702A(c)(2)(A) decrease and a
retrospective MEC.

[56]
Presumably the QAB was not funded past its expiry date, so
the quantities B and C would cancel.

[58]
Thus, for instance, increases due to payments under the ROP death
benefit option are not material changes because of the necessary
premium exception.
Cf. ¶5/8.

[59]
Treating as material changes only adjustment events that
increase the guideline limit can allow payment of
unnecessary premium under a GPT contract, for instance if
endowment benefits are reflected, or if guideline premiums
are not strictly nondecreasing by duration for a given issue
age, as might occur with high expense charges applicable in
the first year only.

Furthermore, consider a change from an increasing to a level
death benefit option that is not accompanied by any change
in death benefit.
The guideline limit decreases.
Page 654 of
the DEFRA Blue Book implies that this is as much a material
change as any other §1035 exchange.
“Further, under prior
and present law, for the purpose of the adjustment rules,
any change in the terms of a contract that reduces the
future benefits under the contract will be treated as an
exchange of contracts (under sec. 1035)…. This provision
was intended to apply specifically to situations in which a
policyholder changes from a future benefits pattern taken
into account under the computational provision for policies
with limited increases in death benefits to a future benefit
of a level amount (even if at the time of change the amount
of death benefit is not reduced).” (The enactment of
§7702(f)(7)(B–E) superseded this part of the legislative
history with respect only to certain changes during the
first fifteen years.)

[60]
Applying both rules to decrease adjustments is conservatively
less advantageous to the taxpayer, but seems so extraordinary
on the face of it that some elaboration is in order.
The rollover rule must be applied because that is the way this
method keeps the necessary-premium and definitional guidelines
synchronized.
The reduction rule must be applied because recognizing a material
change does not satisfy §7702A(c)(2)(A).
We handle the reduction first, using its seven-pay premium for
retrospective testing; then process the material change, using
its seven-pay premium for prospective testing.

[62]
To prevent systematic abuse, a pro-rata portion of the amount
paid in the old contract year could be deducted from the
seven-pay limit in the first new contract year (cf. ¶5/10).
For example, suppose a $1000 premium is paid on anniversary, and
then the seven-pay premium becomes $2000 due to a material
change nine months later.
Only nine-twelfths of the $1000
payment is attributable to the completed portion of the old
contract year, so the other $250 = 1000 × [1 − (9 ÷ 12)] must
be attributed to the new contract year about to begin.
Thus, for the twelve months following the material change,
premiums are limited to $2000 − 250 = 1750.
If this adjusted limit is negative, then the premium limit for
that year is zero, consistent with page 1439 of the OBRA House
Report; but no forceout is required.
Any such rule would be added to
the procedures for CVAT MEC testing as well.

[63]
§7702A(c)(3)(B)(i) says “the lowest level of the death
benefit and qualified additional benefits payable in the 1st
7 contract years”. But §7702(c)(2)(A) forces that to equal
the level in the first contract year.
As long as the benefits are properly updated, LDB is always the
benefit as of the beginning of the first contract year.

[64]
Amortized QAB charges means the present value of QAB
charges divided by a seven-year annuity-due factor,
with the annuity period duly reduced if it would otherwise
extend past maturity.

[66]
If the net 1035 amount exceeds the necessary premium, we
declare the contract a MEC, though some might hold that it is
not—reasoning, perhaps, that the CVAT corridor saves it.
Cf. the general recommendation in ¶3/1.

[71]
TAMRA Conference Report, footnote 3.
Policy loans affect AV in that loaned and unloaned funds
generally earn different rates of interest, but that has no
effect because the DCV interest rate is prescribed by statute.

[73]
TAMRA Conference Report, page 98: “as of the date that the
material change takes effect”. For instance, it is not
permissible to delay recognition of a material change to the
next monthiversary or anniversary.

[74]
If the restriction suggested in a footnote to ¶13/4 is
desired, apply it here.
I.e., in the first contract year only, reduce the new seven-pay
premium by a pro-rata portion of the amount paid in the
partially-completed former contract year.

[76]
This means that decreases occurring outside the seven-year
test period on a CVAT contract are ignored.

[77]
It is unduly harsh to process the decrease while ignoring
the increase, even though the necessary premium exception
may permit that.
In order to recognize the increase, a
material change must be declared.

[78]
Another interpretation is that it becomes a retrospective
MEC as of the (past) failure date, but [TODO ?? cite
anticipation rules described elsewhere].
At any rate, it is
most likely too late to refund the offending premium.

[79]
If the misstatement is discovered prior to death, the
premium or mortality charge might be adjusted instead of the
benefits, and some would hold that this is not a material
change.

[80]
Some would hold that underwriting liberalizations are not
material changes.

[81]
Insurers could manually administer cases for which it behooves
them to recognize a material change.

[82]
Irregular premium, withdrawal, and SA patterns are easily
handled.
Option changes and loans can be handled with more work.
Calculations that depend on other calculated values,
such as waiver of monthly deductions, corridor death
benefits, banded COI rates, and tiered loads are
considerably more difficult, but can be handled by iterating
vector commutation-function equations.
Exact rounding of intermediate values cannot be modeled at all.